Articles

Money for Nothing

BRUSSELS – The developed world seems to be moving toward a long-term zero-interest-rate environment. Though the United States, the United Kingdom, Japan, and the eurozone have kept central-bank policy rates at zero for several years already, the perception that this was a temporary aberration meant that medium- to long-term rates remained substantial. But this may be changing, especially in the eurozone.

Strictly speaking, zero rates are observed only for nominal, medium-term debt that is perceived to be riskless. But, throughout the eurozone, rates are close to zero – and negative for a substantial share of government debt – and are expected to remain low for quite some time.

In Germany, for example, interest rates on public debt up to five years will be negative, and only slightly positive beyond that, producing a weighted average of zero. Clearly, Japan’s near-zero interest-rate environment is no longer unique.

To be sure, the European Central Bank’s large-scale bond-buying program could be suppressing interest rates temporarily, and, once the purchases are halted next year, they will rise again. But investors do not seem to think so. Indeed, Germany’s 30-year bund yield is less than 0.7%, indicating that they expect ultra-low rates for a very long time. And many issuers are extending the maturity structure of their obligations to lock in current rates, which cannot go much lower (but could potentially increase a lot).

In any case, the eurozone seems stuck with near-zero rates at increasingly long maturities. What does this actually mean for its investors and debtors?

Here, one must consider not only the nominal interest rate, but also the real (inflation-adjusted) interest rate. A very low – or even negative – nominal interest rate could produce a positive real return for a saver, if prices fall sufficiently. In fact, Japanese savers have been benefiting from this phenomenon for more than a decade, reaping higher real returns than their counterparts in the US, even though Japan’s near-zero nominal interest rates are much lower than America’s.

Nonetheless, nominal rates do matter. When they are negligible, they flatter profit statements, while balance-sheet problems slowly accumulate.

Given that balance-sheet accounting is conducted according to a curious mix of nominal and market values, it can be opaque and easy to manipulate. If prices – and thus average debt-service capacity – fall, the real burden of the debt increases. But this becomes apparent only when the debt has to be refinanced or interest rates increase.

In an environment of zero or near-zero interest rates, creditors have an incentive to “extend and pretend” – that is, roll over their maturing debt, so that they can keep their problems hidden for longer. Because the debt can be refinanced at such low rates, rollover risk is very low, allowing debtors who would be considered insolvent under normal circumstances to carry on much longer than they otherwise could. After all, if debt can be rolled over forever at zero rates, it does not really matter – and nobody can be considered insolvent. The debt becomes de facto perpetual.

Japan’s experience illustrates this phenomenon perfectly. At more than 200% of GDP, the government’s mountain of debt seems unconquerable. But that debt costs only 1-2% of GDP to service, allowing Japan to remain solvent. Likewise, Greece can now manage its public-debt burden, which stands at about 175% of GDP, thanks to the ultra-low interest rates and long maturities (longer than those on Japan’s debt) granted by its European partners.

In short, with low enough interest rates, any debt-to-GDP ratio is manageable. That is why, in the current interest-rate environment, the Maastricht Treaty’s requirement limiting public debt to 60% of GDP is meaningless – and why the so-called “fiscal compact” requiring countries to make continued progress toward that level should be reconsidered.

In fact, near-zero interest rates undermine the very notion of a “debt overhang” in countries like Greece, Ireland, Portugal, and Spain. While these countries did accumulate a huge volume of debt during the credit boom that went bust in 2008, the cost of debt service is now too low to have the impact – reducing incomes, preventing a return to growth, and generating uncertainty among investors – that one would normally expect. Today, these countries can simply refinance their obligations at longer maturities.

Countries’ debts undoubtedly play a vital role in the global financial system. But, in a zero interest-rate environment, that role must be reevaluated.